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Thursday, May 30, 2013

Yesterday we reviewed the extreme euphoric sentiment levels in the U.S. stock market along with the incredible amount of leverage being used to propel stocks higher in Stock Optimism Now Bet With Maximum Leverage: Gold Sees Mirror Image. Today we will briefly review the prices being paid for these stocks in relation to their earnings, as investors bet on not being the last one out when the building catches on fire.

Vitaliy Katsenelson wrote a book a few years back called The Little Book Of Sideways Markets. The book was focused on showing how markets move through long periods of secular bull and bear markets, usually lasting between 15 to 20 years. During the bull market periods the market moves up with cyclical corrections down along the way. During bear market periods the market moves sideways, with cyclical corrections up along the way.

The following provides an excellent visual of this trend showing the bull market rise from 1949 to 1966, followed by the secular bear market sideways movement from 1966 to 1982, followed by the secular bull market rise from 1982 to 2000, followed by the secular bear market sideways movement from 2000 to present. What is even more interesting is that these secular moves tend to occur in intervals of exactly 17.6 years, providing us a guide point for the range of time when this current secular bear market will end.

During the peak of secular bull markets (2000) stocks get overvalued because investors bid up what they pay for earnings, which can be tracked using P/E ratios.

A bear market is the cleansing process of working out those overvaluations and extreme sentiment levels bringing P/E ratios back down to a single digit range (1982). At a bear market bottom when a new secular bull market is ready to begin, no one wants to own stocks, allowing price to earnings ratios to fall to extreme lows.

The following shows where we stand in this process. The P/E ratio today is currently where secular bull markets have ended in the past (extreme overvaluation). The euphoria in the market is incredible when compared to the underlying fundamentals of the earnings behind the stocks. Based on history, we are now at a point of maximum danger as we move closer to entering the next cyclical leg down in the current secular bear market.

Vitaliy wrote an article this week discussing where we are in this process. One of the things I found fascinating was that he wrote articles and gave speeches back in 2007, during the peak of the last counter trend rally, and he said he could now use many of the same materials he used back then because the same process of overvaluation and higher sentiment levels have returned like an echo.

A chart from his discussion seen below was regarding share buybacks. One of the most "bullish" comments you hear from the mainstream financial world is that companies are buying back their stocks which will push prices even higher. History shows that companies buy stocks heavily at market peaks and stay out of the market at bottoms. In the third quarter of 2007 (the last peak) companies bought back a record $172 billion. In the first quarter of 2009 (the bottom) companies purchased $31 billion in their own shares; 80% less.

The next historical visual shows earnings vs. GDP dating back to 1950. You can see that earnings always revert back to the true growth of the country they are found in. This is important if you believe the global economy, or the country you own shares in, may be slowing as we move forward.

The 10 year treasury bond has risen to 2.13% which is now higher than the S&P 500's dividend yield.

How much higher can stock prices goes in comparison to their underlying fundamentals? Much higher. In our financial markets today, due to the liquidity and leverage, we move through a process of rolling bubbles. My only concern with playing with the fire in the market is that in today's high frequency trading world a large scale market crash can now occur in a matter of minutes. If you get up to go to the bathroom, a large part of your portfolio may not be there when you return.

Buying stocks today can be described as picking up pennies in front of a steam roller. Proceed with caution.

Wednesday, May 29, 2013

The following chart from The Short Side Of Long shows a composite of three of the largest sentiment readings (blue line) for the U.S. stock market heading into this week: AAII, Investors Intelligence, and NAAIM. If you click on the chart there is a dotted red line showing that we have crossed back into "frothy" territory on the sentiment readings.

The daily sentiment index has hovered between 75% and 90% over the last month. It touched 92% this month, meaning that 92% of stock market traders polled currently believe the market is going higher.

At the bottom in March 2009 it showed a polling of 2% bulls, meaning that 98% believed that stocks were going lower.

In addition to sentiment, leverage continues to soar higher. The following shows the NYSE Margin reaching a new all time record high (which was surpassed yesterday). As everyone believes the market will go higher, forever, they continue to bet more and more with borrowed money.

In another market, gold, we also record positions taken with leverage, only it is on the opposite side. The commitment of trades report shows that there is now the largest short position on gold in 17 years. Traders are betting with leverage that prices will plunge from here. If prices happen to rise, which no one expects is a possibility based on current sentiment readings, then they would have to "cover" these shorts or buy gold.

While stocks are setting up perfectly for a liquidation based on sentiment and leverage, gold is setting up for a spectacular short covering rally.

I only recommend caution if you choose to be part of the rest of the world that is currently 100% long stocks and 100% sold out of precious metals.

The Japanese stock market recently touched 96% bullish on the daily sentiment reading with a ten day average of 93.8% bullish before their market crashed 15% in just a few days. For more see:

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"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

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- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

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"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

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"None are more hopelessly enslaved than those that falsely believe they are free."

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"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

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Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

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"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

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"The market can stay irrational longer than the investor can stay solvent."

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"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

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The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

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"Give me control of a nations money supply, and I care not who makes it's laws."

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Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

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Many of life's failures are people who did not realize how close they were to success when they gave up.